Borrowing costs

Corporate borrowing costs rise as Fed braces for rate hikes

Federal Reserve Board Chairman Jerome Powell is expected to announce several rate hikes throughout 2022 to combat runaway inflation.
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Corporate borrowing costs are rising ahead of much-anticipated Federal Reserve interest rate hikes, a potential sign of trouble for companies looking to raise cash in 2022. Healthy corporate balance sheets and expected growth profits, however, will minimize any credit risk for companies with more costly debt.

Corporate bond spreads – the premium investors earn by buying corporate bonds instead of government bonds – widened amid a broader rise in yields. Bond yields rise as prices fall, which means companies get less for their money when issuing debt securities. This effectively increases borrowing costs, making it more expensive to refinance or raise capital to invest in M&As or capital expenditures.

Demand for risky assets has weakened as the Federal Reserve seeks to tighten monetary policy in the era of the pandemic by raising interest rates and shrinking the size of its balance sheet by $9 trillion , removing a key element of demand for government bonds that has forced private investors to shift to other assets such as corporate bonds and equities.

The option-adjusted spread of the S&P US Investment Grade Corporate Bond Index widened to 112 basis points as of February 22, from 93 basis points at the start of the year and the highest level since November. 2020. The lowest-rated high-yield bond spread widened to a one-year high, hitting 368 basis points on Feb. 18 from 299 basis points at the start of the year. The high yield spread stood at 365 basis points on February 22.

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Investment grade bond spreads could widen to 130 basis points by mid-year on the heels of Fed actions, said Viktor Hjort, global head of credit strategy at BNP Paribas. It would be “historically the most important decision without there being a recession,” Hjort said.

These measures could cause problems for companies that have taken on debt during the pandemic, especially those in the riskier high-yield category, where spreads have increased further. Still, US companies largely have healthy balance sheets, and expectations of further earnings growth have eased investor concerns.

“We consider the fundamentals to be still quite strong,” Greg Staples, head of North America fixed income at DWS, said in an email. “Companies have been bolstering liquidity and extending maturities. We don’t see a major upturn in downgrades, let alone bankruptcies.”

Institutions will respond to demand

The Fed has cut corporate bond yields to historic lows during the pandemic, while injecting liquidity into markets to ensure businesses have access to funding. The Fed purchased trillions of dollars in government bonds and mortgage-backed securities under this quantitative easing program, crowding investors into riskier assets such as corporate bonds and reducing yields as bond prices rose.

As the Fed scales back its bond purchases and officials plan to start selling some of the assets on the central bank’s $9 trillion balance sheet, a major source of bond demand is emerging from the fray.

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“There will be less demand [for corporate bonds]no no demand,” Hjort said. “There will still be decent demand from pension funds that have very high funded ratios and a strong incentive to reallocate to fixed income, and from insurance for which the higher long-term returns enable them to achieve their return objectives.”

Asset managers will likely reduce their purchases of corporate bonds in line with the Fed’s balance sheet reduction, but others will be pressured to intervene as prices fall. Meanwhile, institutional investors – who are less price-sensitive and need to hold high-quality government and corporate bonds for regulatory reasons – will be attracted to cheaper bonds.

“The more aggressive the market prices for rate hikes, the more excited we are about the potential opportunity,” Nick Hayes, head of Global Strategic Bond strategy at AXA Investment Managers, said in an email.

Improved fundamentals

Although spreads have increased, they remain at historically low levels. This will likely keep companies in the bond market, even if demand drops, to fund M&As and share buybacks as they did in 2021 at record highs.

According to S&P Global Ratings, only 13% of US companies have a negative outlook or are at risk of being downgraded. It’s the lowest number at the start of a year since 2015 and just two percentage points above the all-time low.

“They’re going to face higher funding costs, but not enough to change the fundamentals anytime this year, and I don’t think that changes their spending outlook,” Hjort said.

Robust earnings growth has boosted businesses in 2021 as the economy rebounded. Recent data has been patchy, with U.S. retail sales falling 2.5% in December before growing 3.8% in January and the The University of Michigan Consumer Sentiment Index fell to a 10-year low in February.

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Some believe the Fed will be very flexible in how it tightens policy to ensure borrowing costs don’t rise too sharply.

“We think [there is] an expectation that central bank corporate bond programs could be rolled back if the economic situation were to deteriorate sharply,” Nicholas Farr, deputy economist at Capital Economics, said in an email, noting that such a decision “should prevent spreads from increasing much further.”